In the last Governing Meeting on July 22, President Christine Lagarde rolled out a new framework for European Central Bank policy that included a formal commitment to a symmetric 2% inflation target.
While this was a significant step, the ECB had informally embraced this target for some time already, since 2019, and so the major new development for markets was not that, but rather the Governing Council’s adoption of a new forward rate guidance that committed the central bank to keeping rates at current or lower levels until certain criteria have been met.
Markets took notice, and already modest rate hike expectations were pushed even further out into the future. But where markets and many analysts appear to be misguided is in assuming the new framework will also translate into an extension or even an increase by the ECB of its current 1.85 trillion euros PEPP bond purchase program (Pandemic Emergency Purchase Program).
Indeed, it appears that if everything goes according to plan, the ECB will decide to tweak its PEPP purchases modestly downwards when the Governing Council meets next on Thursday, September 9.
The PEPP Debate
Speculation over the PEPP, and asset purchases in general, was fueled last Thursday when ECB Chief Economist and Board Member Philip Lane stated that “rate forward guidance” was “just the first step” in implementing the ECB’s new strategy. Markets took this to mean a parallel forward guidance commitment on bond purchases could be forthcoming.
But while President Lagarde was successful in forging consensus over strong objections from hawkish National Central Bank governors to guidance that would lock in low rates even further, there was, and is, no consensus within the Governing Council to lock the ECB into asset purchase guidance that could risk putting the Eurozone into a Japan-like, “QE forever” trap.
In the words of one ECB official, asset purchases are still a non-conventional (or ”non-standard”), even if by now familiar, tool in the Governing Council’s arsenal. And so “we will be here [with purchases] for 10 years, maybe a little less” (the Asset Purchase Program kicked off in earnest in 2015).
As to the PEPP, the ECB will remain ready to use all the tools at its disposal, including net new asset purchases and reinvestments, to meet its 2% inflation target. But the real crisis and Covid emergency for which the “E” in the “PEPP” stands will be largely in the rear-view mirror when that program is set to expire at the end of March of 2022.
With a sustainable 2% inflation forecast elusive still – at least for now — the ECB will ensure that extremely accommodative monetary conditions remain in place next spring by topping up its longer standing APP (Asset Purchase Program), but it will not extend the PEPP, even if that hurts, on the margins, the peripheral bond markets (see SGH 6/28/21, “ECB: A Glidepath for Bond Purchases”).
As opposed to the APP guidelines, the PEPP of course allows the central bank to purchase sovereign bonds free of any national Capital Key purchase limits on an “emergency” basis, favoring the non-core, peripheral bond markets. But with sovereign bond yields at historically compressed levels, the broad consensus within the ECB is that there will be no pressing need by April 2022 to continue favoring peripheral markets anymore — despite public lobbying by southern European National Central Banks already to extend or increase the PEPP.
Adjusting the Existing PEPP Program
Furthermore, our understanding is that if the Eurozone data stays roughly on expectations over the next two weeks, the ECB will most likely decide to tweak its PEPP purchases modestly downwards for the fourth quarter when the Governing Council meets next on Thursday, September 9.
Indeed, we are told that markets here may have missed a subtle hint to that effect by ECB Chief Economist Philip Lane, even as they over interpreted his comments on new announcements and guidance.
Yesterday, Lane noted that while sovereign yields are a little higher than they were at the turn of the year, they are substantially lower than where they were after the Fed-fueled mini-tantrum (our characterization, not his) of last spring.
With an eye on market pricing and expectations, and with the experience of years of undershooting on its inflation targets seared in the collective memories of the ECB, Lane leans dovish, and cautious, in his communications.
Our understanding is that these comments should be taken not simply on face value as a statement of fact, but also to imply that there is a middle way on financial conditions that could now be extended to how aggressively the PEPP purchase program is applied while still maintaining aggressively easy monetary conditions.
In plain English, this means that PEPP purchases can be adjusted modestly downwards from the current roughly 80 billion euro per month pace for the fourth quarter of 2021, and then potentially stepped down again a bit for Q1 of 2022.
With the ECB purchasing considerably more bonds than are being issued, and issuance likely to drop, these “adjustments” (the ECB prefers to shy away from the more aggressive connotations around the term “taper”) will be presented to reflect changing market and financial conditions, and a small step back from massive emergency interventions.
And with the APP facility ready to be boosted should additional accommodation be needed in 2022, the ECB will continue to emphasize its commitment to “forceful and persistent” monetary policy accommodation when in proximity to the effective lower bound on rates, even as the PEPP is effectively wound down as planned.